Moment of Truth for US Stocks

For even the strongest market rallies there comes a time, a moment of truth, when earnings and the prospect of future earnings need to support continued market growth. When that does not happen, the rally will fizzle or even crash. According to Market Watch that moment of truth for US stocks will come sooner rather than later.

The next two weeks in the U.S. stock market are bound to be more interesting than usual as companies begin reporting third-quarter results and central banks around the world start talking in earnest of draining liquidity from the financial system.

The market could move quickly, so we need to be ready. I have a strategy designed for that, and so should you.

Demand for stocks, bonds and real estate are driven by liquidity. The more money that chases those asset classes, the higher those investments’ prices will rise. That is simple supply and demand, and it works on both sides.

The author writes that there are two possible routes forward based on supply and demand of investment vehicles, namely stocks and bonds. A case in point is the Fed’s decision to start liquidating its bond portfolio. Another is the European Central banking printing about $60 billion worth of money each month.

The Federal Reserve announced last month that they would start to reduce their $4.5 trillion balance sheet in October, thereby starting the process we call Quantitative Tightening (QT). As expected, they are aiming to do it gently and quietly, by not reinvesting bonds as they mature, starting with sums of around $6 billion of Treasuries and $4 billion in Mortgage-Backed Securities (MBS). The scale of non-reinvestment will gradually increase. Once in full swing, the Fed’s balance sheet could reduce by up to $150 billion each quarter.

Conventional analysis might conclude that the Fed’s balance sheet reduction (deflation) would be bad for US Treasuries and MBS — after all, those are the instruments not now being bought by the Fed. Notwithstanding the fact that we dismiss that sort of causality thinking anyway, we’re not conventional analysts, and take a different angle.

As the Insights column of our Interest Rates Pro Service alluded to last month, the Fed’s QE program has crowded out investors in the US Treasury space. The market supply of US Treasuries was reduced by the Fed’s program and so it forced bond investors to buy other instruments, such as corporate bonds. Now that more US Treasuries are going to be available for investment, those funds may be tempted to switch the corporate bonds they hold back into (“safer”) US Treasuries. The unintended consequence of QT, therefore, may well turn out to be a widening in corporate bond yield spreads.

The point is that this could be a moment of truth for US stocks and bonds as a big chuck of equity gets removed from the markets and interest rates ease up as well.

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